Cash Management

Chapter Objectives
Explain the reasons for holding cash:
Underline the need for cash
management.
Discuss the techniques of preparing
cash budget.
Focus on the management of cash
collection and disbursement.
Emphasise the need for investing
surplus cash in marketable securities.

Cash Management
Cash management is concerned with
the managing of:
cash flows into and out of the firm,
cash flows within the firm, and
cash balances held by the firm at a point of
time by financing deficit or investing
surplus cash

Four Facets of Cash

Management

Cash planning
Managing the cash flows
Optimum cash level
Investing surplus cash

Motives for Holding Cash

The transactions motive
The precautionary motive
The speculative motive

Cash Planning
Cash planning is a technique to plan
and control the use of cash.
Cash Forecasting and Budgeting
Cash budget is the most significant device
to plan for and control cash receipts and
payments.
Cash forecasts are needed to prepare cash
budgets.

Short-term Cash Forecasts

The important functions of short-term
cash forecasts
To determine operating cash requirements
To anticipate short-term financing
To manage investment of surplus cash.

Short-term Forecasting Methods

The receipt and disbursements method
The adjusted net income method.

The Receipt and

Disbursements Method

The virtues of the receipt and payment methods

are:
It gives a complete picture of all the items of expected
cash flows.
It is a sound tool of managing daily cash operations.
This method, however, suffers from the following
limitations:
Its reliability is reduced because of the uncertainty of
cash forecasts. For example, collections may be
delayed, or unanticipated demands may cause large
disbursements.
It fails to highlight the significant movements in the
working capital items.

The Adjusted Net Income

Method
The benefits of the adjusted net
income method are:
It highlights the movements in the working
capital items, and thus helps to keep a control
on a firms working capital.
It helps in anticipating a firms financial
requirements.

The major limitation of this method is:

It fails to trace cash flows, and therefore, its
utility in controlling daily cash operations is
limited.

Long-term Cash Forecasting

The major uses of the long-term cash
forecasts are:
It indicates as companys future financial needs,
especially for its working capital requirements.
It helps to evaluate proposed capital projects. It
pinpoints the cash required to finance these
projects as well as the cash to be generated by
the company to support them.
It helps to improve corporate planning. Longterm cash forecasts compel each division to
plan for future and to formulate projects
carefully.

Managing Cash Collections

and Disbursements

Accelerating Cash Collections

Decentralised Collections
Lock-box System

Controlling Disbursements
Disbursement or Payment Float

Features of Instruments of
Collection in India

Optimum Cash Balance

Optimum Cash Balance under
Certainty: Baumols Model
Optimum Cash Balance under
Uncertainty: The MillerOrr Model

Baumols ModelAssumptions:
The firm is able to forecast its cash
needs with certainty.
The firms cash payments occur
uniformly over a period of time.
The opportunity cost of holding cash is
known and it does not change over time.
The firm will incur the same transaction
cost whenever it converts securities to
cash.

Baumols Model

The firm incurs a holding cost for keeping the cash balance. It is
an opportunity cost; that is, the return foregone on the marketable
securities. If the opportunity cost is k, then the firms holding cost for
maintaining an average cash balance is as follows:
Holding cost = k (C / 2)
The firm incurs a transaction cost whenever it converts its
marketable securities to cash. Total number of transactions during
the year will be total funds requirement, T, divided by the cash
balance, C, i.e., T/C. The per transaction cost is assumed to be
constant. If per transaction cost is c, then the total transaction cost
will be:
Transaction cost = c(T / C )
The total annual cost of the demand for cash will be:
Total cost = k (C / 2) c(T / C )
The optimum cash balance, C*, is obtained when the total cost is
minimum. The formula for the optimum cash balance is as follows:
2cT
C*
k

The MillerOrr Model

The MO model provides for two control limits
the upper control limit and the lower control
limit as well as a return point.
If the firms cash flows fluctuate randomly and
hit the upper limit, then it buys sufficient
marketable securities to come back to a normal
level of cash balance (the return point).
Similarly, when the firms cash flows wander
and hit the lower limit, it sells sufficient
marketable securities to bring the cash balance
back to the normal level (the return point).

The Miller-Orr Model

The difference between the upper limit
and the lower limit depends on the
following factors:
the transaction cost (c)
the interest rate, (i)
the standard deviation () of net cash flows.

The formula for determining the distance

between upper and lower control limits
(called Z) is as follows:

Investing Surplus Cash in

Marketable Securities
Selecting Investment Opportunities:
safety,
Maturity, and
marketability.